Tuesday, July 11, 2006

Keeping in perspective the inflation risk

In both the United States and the euro zone, headline inflation has risen above target rates (4% and 2.5%, respectively). Although core inflation tends to remain under better control, it is accelerating in the United States, and is poised to rise in the euro zone as well.

In response, the Fed raised its key target rate to 5.25%, and the ECB will surely follow suit, raising the refinancing rate to 3.50% before the end of the year. This tightening movement is likely to be followed by a pause, at least according to the signals suggested by economic fundamentals, especially if monetary policy is to be considered “forward looking”.

It is important to keep in mind the following factors:
1) Inflation - and core inflation in particular - is a lagging indicator.
2) The moderating impact of past rate hikes has not materialised yet.
3) The American and European economies are heading for a slowdown next year, which means that growth rates are likely to fall below their long-term potential. This should buffer the impact of inflationary pressures, and current fears should gradually ease.

Yet, more is at play. In increasingly open economies, inflation rates no longer depend solely on internal conditions. Imports, particularly those from emerging market countries with low wage costs, are making a greater contribution to domestic demand. The risks of imported inflation are reduced by the enormous surplus production capacity worldwide. This is true in terms of physical plant (China’s high investment rate is very telling) and in the scope of under-employed labour in the countryside – the steady stream of labour toward urban areas and non-farm sectors is accompanied by greater productivity gains as well as by a moderating impact on wages. Moreover, the opening of markets to the exterior strains wage formation in the developed countries.

Real wages, in both the United States and the Eurozone, are not rising as fast as one would expect at this stage of the cycle: traditional Phillips curves no longer reflect the relationship between unemployment and wages. Several factors have curbed wage momentum: globalisation and the fear that production will be relocated abroad; restructuring and the impact of legal and illegal immigration on protected sectors like construction and services, which cannot be relocated abroad. In an environment marked by the internationalisation of all markets – financial, goods & services and labour – monetary policy decisions can no longer be based solely on internal conditions like unemployment or, to a broader extent, production capacity utilisation rates.

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United Kingdom widening current account poses no serious risk

The UK current account has been in deficit since 1984. In 2005, the deficit stood at 2.2% of GDP. In 2006 Q1, the deficit rose to 2.6% of GDP. These data imply that the UK has been a net seller of assets to non-residents for more than 20 years. One could question if such a long period of deficits could continue unabated.

The structure of the current account
Looking at the current account, one is struck by several aspects. Since 1946, imports of goods have exceeded exports in almost every year. Moreover, in recent years, the trade deficit has been widening. It stood at around 1.6% of GDP in the middle of the 1990s and reached 5.5% in 2005. This is due to the continuing decline of the British manufacturing sector. The deficit of the trade balance has been compensated by surpluses on the services and income balances. Services exports are now about 50% of goods exports, confirming that the British economy is becoming more and more a services-oriented economy.

In particular, the UK wholesale financial services sector ("the City") has established itself as one of the major international financial centres in terms of liquidity and product diversification. In recent year, the surplus on the services balance has been fluctuating in a narrow band between 1.5-2.5% of GDP. The most remarkable fact is the strengthening of the incombe account.

Its surplus rose from close to balance in the mid 1990s to 2.4% by 2005, thus limiting the deterioration of the current account. This development was remarkable, as one would have expected that the continuing sale of assets to non-residents
would have led to weakening of the income account.

The UK net asset position
Both UK gross foreign assets and liabilities have dramatically risen during the past 40 years, from around 40% of GDP in 1966 to close to four times GDP by the end of 2005. However, due to accumulation of deficits on the current account, liabilities have risen more rapidly than assets, and since 1995, the net asset position has been negative. What stands out in this development is the improvement in the direct investment balance. It implies that UK residents have been buying foreign firms, sometimes in exchange of equities. For example, in 2000, direct investment was dominated by the purchase of Mannessman by Vodaphone. As this was financed by an exchange of shares, it appeared in the accounts as a large direct investment inflow balanced by an equity outflow in portfolio investment.

Direct investments tend to be underestimated in the accounts as they are measured at book value. Only non-repatriated profits are added to the stock of direct investment (and also on the current account as income from abroad). By collecting data on the difference between the valuation against book value and market value of 167 companies, Pratten suggests book value ratios of 1.75% for outward investment and 1.50 for inward investment.
- 1 Using these estimates, Nickell calculates that the overall net asset position has remained positive, and is virtually unchanged compared with 1990.
- 2 In addition, the returns on different assets vary widely. The implied return on direct investment is generally higher than on other assets. This is even the case after the market value correction. According to Nickell (op. cit.), the substantial improvement in the income balance can be attributed to the sharp rise in the return on direct investment.

The sustainability of the current account largely depends on the development of the trade deficit, and the possibility of the income account to continue to provide a substantial positive contribution. The deficit on trade balance is related to the strong appreciation of sterling and the ensuing losses in competitiveness. We do not project a reversal of this trend. For 2006-2007, the trade balance is projected remain virtually at the same size. The UK’s net portfolio position is strongly positive in equity type instruments (direct investment, equity investment) and strongly negative in debt type investments (debt securities, bank loans,…).

The capital gains on the former are likely to be higher than those on the latter, suggesting that the revaluation of the asset portfolio could continue to offset the current account deficit.

The major risk to this scenario is that the return that foreigners earn on their UK assets would increase substantially compared to the return of UK residents on foreign assets. This could happen if returns on equity investment would come down relative to returns on debt-type instruments.

Although this possibility cannot be excluded in the short-term, it is unlikely to persist in the medium and long term, due to a positive risk premium on equity investment.

A second possibility is that the portfolio composition of non-residents will converge to that of UK residents by foreigners buying more UK equities. An increased appetite for UK assets by non-UK residents is indeed a possibility, but such a development will only be very gradual. Finally, a permanent real appreciation of sterling may lead to a significant fall in UK assets relative to liabilities. As sterling is already overvalued, such a scenario seems rather unlikely. All in all, we expect the financing of the UK current account deficit does not those a serious problem in the medium term.